The hidden risks of going passive

Disaffection with underperforming fund managers can push institutional investors towards ‘passive’ management of their assets. Indeed, the UK’s Department for Communities and Local Government has recently suggested that as much as £85 billion of defined benefit pension fund assets managed for UK local authorities could be moved from active to passive management. The rationale for the suggestion is that the average returns from active management may not justify its higher cost.

While this may be true in a narrow sense, we think it would be a mistake to believe that going passive is a low risk route to success or that it offers a ‘set-and-forget’ approach. We therefore consider the risks of adopting passive approaches.

In this paper we argue that:

Different portfolio returns are the result of both asset allocation and active stock selection decisions.

Active management is required to ensure that capital is allocated efficiently within markets.

Certain types of active managers can be found that outperform passive indices overthe long term, often those with high ‘active share’.

The importance of asset allocation

First and foremost, it is important to remember that one of the biggest decisions any investor makes is how they allocate their assets. For instance, even the best active manager in one asset class will often underperform the worst asset manager in another. In the example in Figure 1 below, the impact of the asset allocation decision is demonstrably more significant than the active-passive decision. It is interesting to note that the difference between the index returns of US large cap equity and US government bonds is approximately 12% over the 3-year period – far more than differences in returns within each asset class. A number of academic studies have confirmed that decisions on allocating to different underlying investment markets account for significant performance differentials between portfolios.

Whether and how much to allocate to different asset classes is therefore a decision of paramount importance. It is also inescapably active – it is impossible to make a ‘passive’ asset allocation decision. However they manage their portfolios, investors cannot avoid making a decision about which broad categories of assets to use: equities, bonds, property, alternatives, etc. Once that course has been charted, the investor needs to make a decision on what vehicle or vehicles to use: whether to use active or passive management to gain access to the assets they have chosen.

Untoward valuation biases

Investing using passive indices can certainly have benefits, including diversification, transparency and low costs, but passive strategies also carry their own risks. For instance, traditional equity indices weight the stocks that they contain by market capitalisation,so that bigger companies dominate. At the end of April 2014, three-quarters of the total value of the MSCI World Index – a benchmark widely followed by passive investors – was accounted for by large cap stocks valued at more than $20 billion.

It may seem intuitive to weight stocks in this way, but there are a number of problems with this approach. One is that investors are buying into yesterday’s winners. These are the biggest stocks which performed well historically, but are now more prone to underperform as smaller stocks erode their market dominance. This effect is evident when a traditional market cap weighted index, such as the MSCI World, is compared with an index that removes the market cap bias, such as the MSCI World Equally Weighted Index. The market cap weighted index lags significantly, as seen in Figure 2 below.

Important Information: The views and opinions contained herein are those of Alistair Jones, UK Strategic Solutions at Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisors only. Not suitable for retail clients. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority. For your security, communications may be recorded or monitored. w45667

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